In the financial industry, credit default swaps (CDSs), request for quotes (RFQs), spread orders, and implied orders are well known.
A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy, or even just having its credit rating downgraded. There are two competing theories usually advanced for the pricing of credit default swaps. The first, referred to as the ‘probability model’, takes the present value of a series of cash flows weighted by their probability of non-default. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds. The second model, proposed by Darrell Duffie, but also by John Hull and White, uses a no-arbitrage approach. Various techniques for valuing credit default swaps and determining their settlement price are known in the industry.
In addition, traders (and others) may submit a request for quote (RFQ or electronic RFQ) to an exchange and/or a regulated trading platform. RFQs are similar to orders submitted to an exchange, however, RFQs differ from an order in that an RFQ is not binding and not actionable. RFQs are well known in the art and commonly used by traders, clearing houses, and/or exchanges to inquire as to the current market for a particular financial instrument. RFQs, however, are sometimes abused. For example, a trader may flood the market with RFQs in an attempt to ascertain other traders' positions on particular financial instruments without binding himself to an order. Those that respond to RFQs (e.g., market makers, other traders, etc.) may disregard the RFQs due to the enormous quantity of RFQs. Unfortunately, a non-abusive RFQ may be left unresponded to because of such behavior. Furthermore, in some scenarios, market makers, which although they are under a contractual obligation to respond to RFQs, may still be less than diligent in responding to RFQs, thus resulting in a negative perception of an exchange. In addition to RFQs, traders may initially request non-binding indicative quotes from market makers, such as described in FIG. 3A and other portions of U.S. Pat. No. 7,584,140, entitled “Method and System for Providing Option Spread Indicative Quotes,” which is incorporated by reference in its entirety herein.
In addition, traders sometimes desire to trade multiple financial instruments in combination using what is often called a spread order. Each component of the combination is called a leg. Traders can define the combination (e.g., an exchange-defined combination) and submit orders for each leg or in some cases can submit a single order for multiple financial instruments to avoid leg risk. Such orders may be called a strategy order, a spread order, or a variety of other names. For example, a spread is an order for the price difference between two contracts with the objective of profiting from a change in the price relationship. The counterparty orders that are matched against the aforementioned combination orders may be individual, “outright” orders or may be part of other combination orders. In the case of spread orders, the matching system may imply the counter party order by using multiple orders to create the counter party order. Examples of spreads include crack, crush, straddle, strangle, butterfly, calendar, and pack spreads.
Appendix E of U.S. Provisional Patent Application Ser. No. 61/438,933 explains that a spread is an order for the price difference between two contracts. This results in the trader holding a long and a short position in two or more related futures or options on futures contracts, with the objective of profiting from a change in the price relationship. A butterfly spread is an order for two inter-delivery spreads in opposite directions with the center delivery month common to both spreads. A calendar spread, also called a intra-commodity spread, for futures is an order for the simultaneous purchase and sale of the same futures contract in different contract months. (i.e., buying a September CME S&P 500® futures contract and selling a December CME S&P 500 futures contract). A crush spread is an order, usually in the soybean futures market, for the simultaneous purchase of soybean futures and the sale of soybean meal and soybean oil futures to establish a processing margin. A crack spread is an order for a specific spread trade involving simultaneously buying and selling contracts in crude oil and one or more derivative products, typically gasoline and heating oil. Oil refineries may trade a crack spread to hedge the price risk of their operations, while speculators attempt to profit from a change in the oil/gasoline price differential.
Appendix E of U.S. Provisional Patent Application Ser. No. 61/438,933 further explains that a straddle is an order for the purchase or sale of an equal number of puts and calls, with the same strike price and expiration dates. A long straddle is a straddle in which a long position is taken in both a put and a call option. A short straddle is a straddle in which a short position is taken in both a put and a call option. A strangle is an order for the purchase of a put and a call, in which the options have the same expiration and the put strike is lower than the call strike, called a long strangle. Also the sale of a put and a call, in which the options have the same expiration and the put strike is lower than the call strike, called a short strangle. A pack is an order for the simultaneous purchase or sale of an equally weighted, consecutive series of four futures contracts, quoted on an average net change basis from the previous day's settlement price. Packs provide a readily available, widely accepted method for executing multiple futures contracts with a single transaction. A bundle is an order for the simultaneous sale or purchase of one each of a series of consecutive futures contracts. Bundles provide a readily available, widely accepted method for executing multiple futures contracts with a single transaction.
Appendix E of U.S. Provisional Patent Application Ser. No. 61/438,933 further explains that by linking the spread and outright markets, implied spread trading increases market liquidity. For example, a buy in one contract month and an offer in another contract month in the same futures contract can create an implied market in the corresponding calendar spread. An exchange may match an order for a spread product with another order for the spread product. Some existing exchanges attempt to match orders for spread products with multiple orders for legs of the spread products. With such systems, every spread product contract is broken down into a collection of legs and an attempt is made to match orders for the legs. Examples of implied spread trading include those disclosed in U.S. patent application Ser. No. 10/986,967, entitled “Implied Spread Trading System,” which is incorporated herein by reference.
Appendix E of U.S. Provisional Patent Application Ser. No. 61/438,933 further explains that, for example, implied IN spreads may be created from existing outright orders in individual contracts where an outright order in a spread can be matched with other outright orders in the spread or with a combination of orders in the legs of the spread. An implied OUT spread may be created from the combination of an existing outright order in a spread and an existing outright order in one of the individual underlying leg. Implied IN or implied OUT spreads may be created when an electronic match system simultaneously works synthetic spread orders in spread markets and synthetic orders in the individual leg markets without the risk to the trader/broker of being double filled or filled on one leg and not on the other leg.
Appendix E of U.S. Provisional Patent Application Ser. No. 61/438,933 further explains that large exchanges typically have order books for numerous spread products and legs of the spread products. However, the identification and processing of potential implied spreads inside electronic trade systems consumes valuable processing resources that could otherwise be used to process outright orders. In a typical central limit order book implementation, the system component for receiving electronic trades from users appears as a single processing thread with a single point of control. In such an implementation, there is a requirement that one order matches only another order, and does not result in two competing processes both matching different orders against a single order. Therefore, implementations have been limited in such trading systems.
In conclusion, implied orders can fill in gaps in the market and allow spread and outright traders to share liquidity in a product where there would otherwise have been little or no available bids and asks. Thus, the liquidity of a product may be enhanced by the use of implied orders. For example, by linking the spread and outright markets, implied spread trading increases market liquidity. Examples of implied spread trading include those disclosed in U.S. patent application Ser. No. 10/986,967, entitled “Implied Spread Trading System,” which is incorporated herein by reference. Large exchanges typically have order books for numerous spread products and legs of the spread products. The identification and processing of potential implied spreads inside electronic trading systems consumes sometimes substantial processing resources. U.S. Pat. No. 7,584,140, entitled “Method and System for Providing Option Spread Indicative Quotes,” which is incorporated by reference in its entirety herein, describes systems and methods for, among other things, minimizing communication bandwidth consumption among parties trading derivative products and other types of financial instruments.
Finally, the Commodity Futures Trading Commission (“Commission” or “CFTC”) is proposing new rules, and guidance and acceptable practices to implement new statutory provisions enacted by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rules, guidance, and acceptable practices, which apply to the registration and operation of a new type of regulated entity named a swap execution facility (SEF), implement the new statutory framework that, among other things, adds a new Section 5h to the Commodity Exchange Act (“CEA”) concerning the registration and operation of swap execution facilities, and new Section 2(h)(8) to the CEA concerning the listing, trading and execution of swaps on swap execution facilities.